Finding the Right Financing Mix: The Capital Structure Decision
Aswath Damodaran
Stern School of Business
First Principles
n Invest in projects that yield a return greater than the minimum acceptable hurdle rate.
• The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)
• Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.
n Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.
n If there are not enough investments that earn the hurdle rate, return the cash to stockholders.
• The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.
Objective: Maximize the Value of the Firm
The Choices in Financing
n There are only two ways in which a business can make money.
• The first is debt. The essence of debt is that you promise to make fixed payments in the future (interest payments and repaying principal). If you fail to make those payments, you lose control of your business.
• The other is equity. With equity, you do get whatever cash flows are left over after you have made debt payments.
Debt versus Equity
Fixed Claim
High Priority on cash flows Tax Deductible
Fixed Maturity
No Management Control
Residual Claim
Lowest Priority on cash flows Not Tax Deductible
Infinite life
Management Control
Debt Hybrids (Combinations Equity
of debt and equity) Debt versus Equity
The Choices
n Equity can take different forms:
• For very small businesses: it can be owners investing their savings
• For slightly larger businesses: it can be venture capital
• For publicly traded firms: it is common stock
n Debt can also take different forms
• For private businesses: it is usually bank loans
• For publicly traded firms: it can take the form of bonds
A Life Cycle View of Financing Choices
Stage 2 Rapid Expansion Stage 1
Start-up
Stage 4 Mature Growth
Stage 5 Decline External
Financing
Revenues
Earnings
Owner’s Equity Bank Debt
Venture Capital Common Stock
Debt Retire debt
Repurchase stock External funding
needs
High, but constrained by infrastructure
High, relative to firm value.
Moderate, relative to firm value.
Declining, as a percent of firm value
Internal financing
Low, as projects dry up.
Common stock Warrants Convertibles
Stage 3 High Growth Negative or
low
Negative or
low Low, relative to
funding needs
High, relative to funding needs
More than funding needs
Accessing private equity Inital Public offering Seasoned equity issue Bond issues Financing
Transitions Growth stage
$ Revenues/
Earnings
Time
The Financing Mix Question
n In deciding to raise financing for a business, is there an optimal mix of debt and equity?
• If yes, what is the trade off that lets us determine this optimal mix?
• If not, why not?
Measuring a firm’s financing mix
n The simplest measure of how much debt and equity a firm is using
currently is to look at the proportion of debt in the total financing. This ratio is called the debt to capital ratio:
Debt to Capital Ratio = Debt / (Debt + Equity)
n Debt includes all interest bearing liabilities, short term as well as long term.
n Equity can be defined either in accounting terms (as book value of equity) or in market value terms (based upon the current price). The resulting debt ratios can be very different.
Costs and Benefits of Debt
n Benefits of Debt
• Tax Benefits
• Adds discipline to management
n Costs of Debt
• Bankruptcy Costs
• Agency Costs
• Loss of Future Flexibility
Tax Benefits of Debt
n When you borrow money, you are allowed to deduct interest expenses from your income to arrive at taxable income. This reduces your taxes.
When you use equity, you are not allowed to deduct payments to equity (such as dividends) to arrive at taxable income.
n The dollar tax benefit from the interest payment in any year is a function of your tax rate and the interest payment:
• Tax benefit each year = Tax Rate * Interest Payment
n Proposition 1: Other things being equal, the higher the marginal tax rate of a business, the more debt it will have in its capital structure.
The Effects of Taxes
You are comparing the debt ratios of real estate corporations, which pay the corporate tax rate, and real estate investment trusts, which are not taxed, but are required to pay 95% of their earnings as dividends to their stockholders. Which of these two groups would you expect to have the higher debt ratios?
r The real estate corporations
r The real estate investment trusts
r Cannot tell, without more information
Implications of The Tax Benefit of Debt
n The debt ratios of firms with higher tax rates should be higher than the debt ratios of comparable firms with lower tax rates. In supporting evidence,
n Firms that have substantial non-debt tax shields, such as depreciation, should be less likely to use debt than firms that do not have these tax shields.
n If tax rates increase over time, we would expect debt ratios to go up over time as well, reflecting the higher tax benefits of debt.
n Although it is always difficult to compare debt ratios across countries, we would expect debt ratios in countries where debt has a much larger tax benefit to be higher than debt ratios in countries whose debt has a lower tax benefit.
Debt adds discipline to management
n If you are managers of a firm with no debt, and you generate high
income and cash flows each year, you tend to become complacent. The complacency can lead to inefficiency and investing in poor projects.
There is little or no cost borne by the managers
n Forcing such a firm to borrow money can be an antidote to the
complacency. The managers now have to ensure that the investments they make will earn at least enough return to cover the interest
expenses. The cost of not doing so is bankruptcy and the loss of such a job.
Debt and Discipline
Assume that you buy into this argument that debt adds discipline to management. Which of the following types of companies will most benefit from debt adding this discipline?
r Conservatively financed (very little debt), privately owned businesses r Conservatively financed, publicly traded companies, with stocks held
by millions of investors, none of whom hold a large percent of the stock.
r Conservatively financed, publicly traded companies, with an activist and primarily institutional holding.
Empirical Evidence on the Discipline of Debt
n Firms that are acquired in hostile takeovers are generally characterized by poor performance in both accounting profitability and stock returns.
n There is evidence that increases in leverage are followed by improvements in operating efficiency, as measured by operating margins and returns on capital.
• Palepu (1990) presents evidence of modest improvements in operating efficiency at firms involved in leveraged buyouts.
• Kaplan(1989) and Smith (1990) also find that firms earn higher returns on capital following leveraged buyouts.
• Denis and Denis (1993) study leveraged recapitalizations and report a median increase in the return on assets of 21.5%.
Bankruptcy Cost
n The expected bankruptcy cost is a function of two variables--
• the cost of going bankrupt
– direct costs: Legal and other Deadweight Costs
– indirect costs: Costs arising because people perceive you to be in financial trouble
• the probability of bankruptcy, which will depend upon how uncertain you are about future cash flows
n As you borrow more, you increase the probability of bankruptcy and hence the expected bankruptcy cost.
Indirect Bankruptcy Costs should be highest for….
• Firms that sell durable products with long lives that require replacement parts and service
• Firms that provide goods or services for which quality is an important attribute but where quality difficult to determine in advance
• Firms producing products whose value to customers depends on the services and complementary products supplied by independent companies:
• Firms that sell products requiring continuous service and support from the manufacturer
The Bankruptcy Cost Proposition
n Proposition 2: Other things being equal, the greater the indirect bankruptcy cost and/or probability of bankruptcy in the operating cashflows of the firm, the less debt the firm can afford to use.
Debt & Bankruptcy Cost
Rank the following companies on the magnitude of bankruptcy costs from most to least, taking into account both explicit and implicit costs:
r A Grocery Store
r An Airplane Manufacturer r High Technology company
Implications of Bankruptcy Cost Proposition
n Firms operating in businesses with volatile earnings and cash flows should use debt less than otherwise similar firms with stable cash flows.
n If firms can structure their debt in such a way that the cash flows on the debt increase and decrease with their operating cash flows, they can afford to borrow more.
n If an external entity, such as the government or an agency of the government, provides protection against bankruptcy through either insurance or bailouts for troubled firms, firms will tend to borrow more.
n Firms with assets that can be easily divided and sold should borrow more than firms with assets that are less liquid.
Agency Cost
n An agency cost arises whenever you hire someone else to do
something for you. It arises because your interests(as the principal) may deviate from those of the person you hired (as the agent).
n When you lend money to a business, you are allowing the stockholders to use that money in the course of running that business. Stockholders interests are different from your interests, because
• You (as lender) are interested in getting your money back
• Stockholders are interested in maximizing your wealth
n In some cases, the clash of interests can lead to stockholders
• Investing in riskier projects than you would want them to
• Paying themselves large dividends when you would rather have them keep the cash in the business.
Debt and Agency Costs
Assume that you are a bank. Which of the following businesses would you perceive the greatest agency costs?
r A Large Pharmaceutical company r A Large Regulated Electric Utility Why?
How agency costs show up...
n If bondholders believe there is a significant chance that stockholder actions might make them worse off, they can build this expectation into bond prices by demanding much higher rates on debt.
n If bondholders can protect themselves against such actions by writing in restrictive covenants, two costs follow –
• the direct cost of monitoring the covenants, which increases as the covenants become more detailed and restrictive.
• the indirect cost of lost investments, since the firm is not able to take certain projects, use certain types of financing, or change its payout; this cost will also increase as the covenants becomes more restrictive.
Implications of Agency Costs..
n The agency cost arising from risk shifting is likely to be greatest in firms whose investments cannot be easily observed and monitored.
These firms should borrow less than firms whose assets can be easily observed and monitored.
n The agency cost associated with monitoring actions and second- guessing investment decisions is likely to be largest for firms whose projects are long term, follow unpredictable paths, and may take years to come to fruition. These firms should also borrow less.
Loss of future financing flexibility
n When a firm borrows up to its capacity, it loses the flexibility of financing future projects with debt.
n Proposition 4: Other things remaining equal, the more uncertain a firm is about its future financing requirements and projects, the less debt the firm will use for financing current projects.
What managers consider important in deciding on how much debt to carry...
n A survey of Chief Financial Officers of large U.S. companies provided the following ranking (from most important to least important) for the factors that they considered important in the financing decisions
Factor Ranking (0-5)
1. Maintain financial flexibility 4.55
2. Ensure long-term survival 4.55
3. Maintain Predictable Source of Funds 4.05
4. Maximize Stock Price 3.99
5. Maintain financial independence 3.88
6. Maintain high debt rating 3.56
7. Maintain comparability with peer group 2.47
Debt: Summarizing the Trade Off
Advantages of Borrowing Disadvantages of Borrowing 1. Tax Benefit:
Higher tax rates --> Higher tax benefit
1. Bankruptcy Cost:
Higher business risk --> Higher Cost 2. Added Discipline:
Greater the separation between managers and stockholders --> Greater the benefit
2. Agency Cost:
Greater the separation between stock- holders & lenders --> Higher Cost
3. Loss of Future Financing Flexibility:
Greater the uncertainty about future financing needs --> Higher Cost
A Qualitative Analysis
Item Boeing The Home Depot InfoSoft
Tax Benefits Significant. The firm has a marginal tax rate of 35%.
It does have large depreciation tax shields.
Significant. The firm has a marginal tax rate of 35%, as well. It does not have very much in non-interest tax shields.
Significant. The owners of InfoSoft face a 42% tax rate. By borrowing money, the income that flows through to the investor can be reduced.
Added Discipline Benefits will be high, since managers are not large stockholders.
Benefits are smaller, since the CEO is a founder and large stockholder.
Benefits are non-existent.
This is a private firm.
Bankruptcy Cost Direct costs are likely to be small, but indirect costs can be substantial..
Direct costs are likely to be small. Assets are mostly real estate. Indirect costs will also be small.
Costs may be small but the owner has all of his wealth invested in the firm.
Agency Costs Low. Assets are generally tangible and monitoring should be feasible.
Low. Assets are stores and real estate, tangible and marketable.
High. Assets are
intangible and difficult to both monitor and to liquidate.
Flexibility Needs Low. Firm has a long gestation period for projects, and knows how much it needs to invest in advance.
Low in existing business, but high, given its plans to grow overseas and online.
Expansion and acquisition needs create need.
High. Firm might have to change its product and business mix, on short notice, as technology changes
6Application Test: Would you expect your firm to gain or lose from using a lot of debt?
n Considering, for your firm,
• The potential tax benefits of borrowing
• The benefits of using debt as a disciplinary mechanism
• The potential for expected bankruptcy costs
• The potential for agency costs
• The need for financial flexibility
n Would you expect your firm to have a high debt ratio or a low debt ratio?
n Does the firm’s current debt ratio meet your expectations?
A Hypothetical Scenario
n Assume you operate in an environment, where
(a) there are no taxes
(b) there is no separation between stockholders and managers.
(c) there is no default risk
(d) there is no separation between stockholders and bondholders (e) firms know their future financing needs
The Miller-Modigliani Theorem
n In an environment, where there are no taxes, default risk or agency costs, capital structure is irrelevant.
n The value of a firm is independent of its debt ratio.
Implications of MM Theorem
(a) Leverage is irrelevant. A firm's value will be determined by its project cash flows.
(b) The cost of capital of the firm will not change with leverage. As a firm increases its leverage, the cost of equity will increase just enough to offset any gains to the leverage.
Can debt be irrelevant in a world with taxes?
n In the presence of personal taxes on both interest income and income from equity, it can be argued that debt could still be irrelevant if the cumulative taxes paid (by the firm and investors) on debt and equity are the same.
n Thus, if td is the personal tax rate on interest income received by investors, te is the personal tax rate on income on equity and tc is the corporate tax rate, debt will be irrelevant if:
(1 - td) = (1-tc) (1-te)
Is there an optimal capital structure? The Empirical Evidence
n The empirical evidence on whether leverage affects value is mixed.
• Bradley, Jarrell, and Kim (1984) note that the debt ratio is lower for firms with more volatile operating income and for firms with substantial R&D and advertising expenses.
• Barclay, Smith and Watts (1995) looked at 6780 companies between 1963 and 1993 and conclude that the most important determinant of a firm's debt ratio is its' investment opportunities. Firms with better investment opportunities (as measured by a high price to book ratio) tend to have much lower debt ratios than firms with low price to book ratios.
n Smith(1986) notes that leverage-increasing actions seem to be accompanied by positive excess returns while leverage-reducing actions seem to be followed by negative returns. This is not consistent with the theory that there is an optimal capital structure, unless we assume that firms tend to be under levered.
How do firms set their financing mixes?
n Life Cycle: Some firms choose a financing mix that reflects where they are in the life cycle; start- up firms use more equity, and mature firms use more debt.
n Comparable firms: Many firms seem to choose a debt ratio that is similar to that used by comparable firms in the same business.
n Financing Heirarchy: Firms also seem to have strong preferences on the type of financing used, with retained earnings being the most
preferred choice. They seem to work down the preference list, rather than picking a financing mix directly.
The Debt Equity Trade Off Across the Life Cycle
Stage 2 Rapid Expansion Stage 1
Start-up
Stage 4 Mature Growth
Stage 5 Decline
Time
Agency Costs
Revenues
Earnings
Very high, as firm has almost no assets
Low. Firm takes few new investments Added Disceipline
of Debt
Low, as owners run the firm
Low. Even if public, firm is closely held.
Increasing, as managers own less of firm
High. Managers are separated from owners
Bamkruptcy Cost
Declining, as firm does not take many new investments Stage 3
High Growth
Net Trade Off Need for Flexibility
$ Revenues/
Earnings
Tax Benefits Zero, if losing money
Low, as earnings are limited
Increase, with earnings
High High, but
declining
Very high. Firm has no or negative earnings.
Very high.
Earnings are low and volatile
High. Earnings are increasing but still volatile
Declining, as earnings from existing assets increase.
Low, but increases as existing projects end.
High. New investments are difficult to monitor
High. Lots of new investments and unstable risk.
Declining, as assets in place become a larger portion of firm.
Very high, as firm looks for ways to establish itself
High. Expansion needs are large and unpredicatble
High. Expansion needs remain unpredictable
Low. Firm has low and more predictable investment needs.
Non-existent. Firm has no new investment needs.
Costs exceed benefits Minimal debt
Costs still likely to exceed benefits.
Mostly equity
Debt starts yielding net benefits to the firm
Debt becomes a more attractive option.
Debt will provide benefits.
Comparable Firms
n When we look at the determinants of the debt ratios of individual firms, the strongest determinant is the average debt ratio of the industries to which these firms belong.
n This is not inconsistent with the existence of an optimal capital structure. If firms within a business share common characteristics
(high tax rates, volatile earnings etc.), you would expect them to have similar financing mixes.
n This approach can lead to sub-optimal leverage, if firms within a business do not share common characteristics.
Rationale for Financing Hierarchy
n Managers value flexibility. External financing reduces flexibility more than internal financing.
n Managers value control. Issuing new equity weakens control and new debt creates bond covenants.
Preference rankings : Results of a survey
Ranking Source Score
1 Retained Earnings 5.61
2 Straight Debt 4.88
3 Convertible Debt 3.02
4 External Common Equity 2.42
5 Straight Preferred Stock 2.22
6 Convertible Preferred 1.72
Financing Choices
You are reading the Wall Street Journal and notice a tombstone ad for a company, offering to sell convertible preferred stock. What would you hypothesize about the health of the company issuing these securities?
r Nothing
r Healthier than the average firm
r In much more financial trouble than the average firm
The Search for an Optimal Financing Mix:
Approaches
n The Operating Income Approach: In this approach, the optimal debt for a firm is chosen to ensure that the probability that the firm will
default does not exceed a management-specified limit.
n The Cost of Capital Approach: In this approach, the optimal debt ratio is chosen to minimize cost of capital, if operating cash flows are unaffected by financing mix, or to maximize firm value.
n The Adjusted Present Value Approach: In this approach, the effect of adding debt to firm value is evaluated by measuring both the tax benefits and the bankruptcy costs.
n The Return Differential Approach: In this approach, the debt ratio is chosen to maximize the difference between ROE and cost of equity.
n Comparables Approach: The debt ratio is chosen by looking at how
I. The Operating Income Approach
n Assess the firm’s capacity to generate operating income based upon past history. The result is a distribution for expected operating income, with probabilities attached to different levels of income.
n For any given level of debt, we estimate the interest and principal payments that have to be made over time.
n Given the probability distribution of operating cash flows, we estimate the probability that the firm will be unable to make debt payments.
n We set a limit on the probability of its being unable to meet debt payments. Clearly, the more conservative the management of the firm, the lower this probability constraint will be.
n 5. We compare the estimated probability of default at a given level of debt to the probability constraint. If the probability of default is higher than the constraint, the firm chooses a lower level of debt; if it is lower
Boeing: Assessing the Probability Distribution
Figure 16.1: Boeing: Operating Income Changes - 1980-98
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5
Estimating Debt Payments
n We estimate the interest and principal payments on a proposed bond issue of $ 5 billion by assuming that the debt will be rated A, lower than Boeing’s current bond rating of AA. Based upon this rating, we estimated an interest rate of 6% on the debt. In addition, we assume that the sinking fund payment set aside to repay the bonds is 5% of the bond issue. This results in an annual debt payment of $ 550 million.
Additional Debt Payment = Interest Expense + Sinking Fund Payment
= 0.06 * 5,000 + .05 * 5,000 = $ 550 million
n The total debt payment then can be computed by adding the interest payment on existing debt in 1998 –– $ 453 million –– to the additional debt payment created by taking on $ 5 billion in additional debt.
Total Debt Payment = Interest on Existing Debt + Additional Debt Payment
= $ 453 million + $ 550 million = $ 1,003 million
Estimating Probability of Default
n We can now estimate the probability of default from the distribution of operating income by assuming that the percentage changes in operating income are normally distributed and by considering the earnings before interest, taxes, depreciation and amortization (EBITDA) of $ 3,237 million that Boeing earned in 1998 as the base year income.
T statistic = (Current EBITDA - Debt Payment) / σOI (Current Operating Income)
= ($ 3,237 - $ 1,003 million) / (.3583 * $3237) = 1.93
n Based upon this t statistic, the probability of default < 3%.
Management Constraints and Maximum Debt Capacity
n Assume that the management at Boeing set a constraint that the probability of default be no greater than 5%.
n If the distribution of operating income changes is normal, we can estimate the level of debt payments Boeing can afford to make for a probability of default of 5%.
T statistic for 5% probability level = 1.645 ($3,237 - X)/ (.3583 * $3,237) = 1.645
Break Even Debt Payment = $ 1,329 million
n If we assume that the interest rate remains unchanged at 6% and the sinking fund will remain at 5% of the outstanding debt, this yields an optimal debt level of $ 12,082 million.
Optimal Debt= Break Even Debt Payment / (Interest Rate + Sinking Fund Rate)
= $ 1,329 / (.06 + .05) = $ 12,082 million
II. The Cost of Capital Approach
n It will depend upon:
• (a) the components of financing: Debt, Equity or Preferred stock
• (b) the cost of each component
n In summary, the cost of capital is the cost of each component weighted by its relative market value.
WACC = ke (E/(D+E)) + kd (D/(D+E))
Recapping the Measurement of cost of capital
n The cost of debt is the market interest rate that the firm has to pay on its borrowing. It will depend upon three components
(a) The general level of interest rates (b) The default premium
(c) The firm's tax rate
n The cost of equity is
• 1. the required rate of return given the risk
• 2. inclusive of both dividend yield and price appreciation
n The weights attached to debt and equity have to be market value weights, not book value weights.
Costs of Debt & Equity
A recent article in an Asian business magazine argued that equity was cheaper than debt, because dividend yields are much lower than interest rates on debt. Do you agree with this statement
r Yes r No
Can equity ever be cheaper than debt?
r Yes r No
Issue: Use of Book Value
Many CFOs argue that using book value is more conservative than using market value, because the market value of equity is usually much higher than book value. Is this statement true, from a cost of capital perspective? (Will you get a more conservative estimate of cost of capital using book value rather than market value?)
r Yes r No
Why does the cost of capital matter?
n Value of a Firm = Present Value of Cash Flows to the Firm, discounted back at the cost of capital.
n If the cash flows to the firm are held constant, and the cost of capital is minimized, the value of the firm will be maximized.
Firm Value, Cost of Capital and Debt Ratios: A Simple Example
n Strunks Inc., a leading manufacturer of chocolates and other candies, has cash flows to the firm of $200 million.
n Strunks is in a relatively stable market, and these cash flows are
expected to grow at 6% forever, and to be unaffected by the debt ratio of the firm.
n The value of the firm at any cost of capital can be written as:
Firm Value = Cash flow to the firm (1+g)/(Cost of capital - g)
= 200 (1.06)/(Cost of capital - .06)
Cost of Capital and Firm Value
D/(D+E) Cost of Equity Cost of Debt WACC Firm Value
0 10.50% 4.80% 10.50% $4,711
10% 11.00% 5.10% 10.41% $4,807
20% 11.60% 5.40% 10.36% $4,862
30% 12.30% 5.52% 10.27% $4,970
40% 13.10% 5.70% 10.14% $5,121
50% 14.00% 6.30% 10.15% $5,108
60% 15.00% 7.20% 10.32% $4,907
70% 16.10% 8.10% 10.50% $4,711
80% 17.20% 9.00% 10.64% $4,569
90% 18.40% 10.20% 11.02% $4,223
100% 19.70% 11.40% 11.40% $3,926
A Pictorial View
Figure 19.2: Cost of Capital and Firm Value
9.40%
9.60%
9.80%
10.00%
10.20%
10.40%
10.60%
10.80%
11.00%
11.20%
11.40%
11.60%
0 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Debt Ratio
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
WACC Firm Value
Current Cost of Capital: Boeing
n The beta for Boeing's stock in March 1999was 1.01. The treasury bond rate at that time was 5%. Using an estimated market risk premium of 5.5%, we estimated the cost of equity for Boeing to be 10.58%:
Cost of Equity = Riskfree rate + Beta * (Market Premium)
=5.00% + 1.01 (5.5%) = 10.58%
n Boeing's senior debt was rated AA;, the estimated pre-tax cost of debt for Boeing is 5.50%. The tax rate used for the analysis is 35%.
After-tax Cost of debt = Pre-tax interest rate (1- tax rate)
= 5.50% (1- 0.35) = 3.58%
n Cost of Capital = Cost of Equity (Equity/(Equity + Debt)) + After-tax Cost of Debt (Debt/(Debt +Equity))
Mechanics of Cost of Capital Estimation
1. Estimate the Cost of Equity at different levels of debt:
Equity will become riskier -> Beta will increase -> Cost of Equity will increase.
Estimation will use levered beta calculation
2. Estimate the Cost of Debt at different levels of debt:
Default risk will go up and bond ratings will go down as debt goes up -> Cost of Debt will increase.
To estimating bond ratings, we will use the interest coverage ratio (EBIT/Interest expense)
3. Estimate the Cost of Capital at different levels of debt 4. Calculate the effect on Firm Value and Stock Price.
Ratings and Financial Ratios
AAA AA A BBB BB B CCC
EBIT interest cov. (x) 12.9 9.2 7.2 4.1 2.5 1.2 (0.9) EBITDA interest cov. 18.7 14.0 10.0 6.3 3.9 2.3 0.2 Funds flow/total debt 89.7 67.0 49.5 32.2 20.1 10.5 7.4 Free oper. cash
flow/total debt (%)
40.5 21.6 17.4 6.3 1.0 (4.0) (25.4)
Return on capital (%) 30.6 25.1 19.6 15.4 12.6 9.2 (8.8) Oper.income/sales
(%)
30.9 25.2 17.9 15.8 14.4 11.2 5.0
Long-term
debt/capital (%)
21.4 29.3 33.3 40.8 55.3 68.8 71.5
Synthetic Ratings
n The synthetic rating for a firm can be estimated by
• Using one of the financial ratios specified above
• Using a score based upon all of the financial ratios specified above
n If you use only one financial ratio, you want to pick the ratio that has the greatest power in explaining differences in ratings.
• For manufacturing firms, this is the interest coverage ratio.
n If you want to use multiple ratios, you have to determine how you will weight each ratio in coming up with a score.
• One approach used is a multiple discriminant analysis, where the weights are based upon how well the ratios predict ultimate default. (Altman Z score is one example).
Process of Ratings and Rate Estimation
n We use the median interest coverage ratios for large manufacturing firms to develop “interest coverage ratio” ranges for each rating class.
n We then estimate a spread over the long term bond rate for each ratings class, based upon yields at which these bonds trade in the market place. (We used a sampling of 5 corporate bonds within each ratings class to make these estimates)
Interest Coverage Ratios and Bond Ratings
If Interest Coverage Ratio is Estimated Bond Rating
> 8.50 AAA
6.50 - 8.50 AA
5.50 - 6.50 A+
4.25 - 5.50 A
3.00 - 4.25 A–
2.50 - 3.00 BBB
2.00 - 2.50 BB
1.75 - 2.00 B+
1.50 - 1.75 B
1.25 - 1.50 B –
0.80 - 1.25 CCC
0.65 - 0.80 CC
0.20 - 0.65 C
< 0.20 D
Spreads over long bond rate for ratings classes: February 1999
Rating Spread Interest Rate on Debt
AAA 0.20% 5.20%
AA 0.50% 5.50%
A+ 0.80% 5.80%
A 1.00% 6.00%
A- 1.25% 6.25%
BBB 1.50% 6.50%
BB 2.00% 7.00%
B+ 2.50% 7.50%
B 3.25% 8.25%
B- 4.25% 9.25%
CCC 5.00% 10.00%
CC 6.00% 11.00%
C 7.50% 12.50%
D 10.00% 15.00%
Current Income Statement for Boeing: 1998
Sales & Other Operating Revenues $56,154.00 - Operating Costs & Expenses $52,917.00
EBITDA $3,237.00
- Depreciation $1,517.00
EBIT $1,720.00
+ Extraordinary Income $130.00
EBIT with extraordinary income $1,850.00
- Interest Expenses $453.00
Earnings before Taxes $1,397.00
- Income Taxes $277.00
Net Earnings (Loss) $1,120.00
Estimating Cost of Equity
n To estimate the cost of equity at each debt ratio, we first estimate the levered beta at each debt ratio:
βlevered = βunlevered [1+(1-tax rate)(Debt/Equity)]
n The levered beta is used in conjunction with the riskfree rate and risk premium to estimate a cost of equity at each debt ratio:
Cost of Equity = Riskfree rate + Beta * Risk Premium
Estimating Cost of Equity: Boeing at Different Debt Ratios
Unlevered Beta = 0.87 (Bottom-up Beta, based upon comparable firms) Market premium = 5.5% Treasury Bond rate = 7.00% t=35%
Debt Ratio Beta Cost of Equity
0% 0.87 9.79%
10% 0.93 10.14%
20% 1.01 10.57%
30% 1.11 11.13%
40% 1.25 11.87%
50% 1.51 13.28%
60% 1.92 15.54%
70% 2.56 19.06%
80% 3.83 26.09%
90% 7.67 47.18%
Estimating Cost of Debt
Firm Value = Market value of debt + Market value of Equity = 32,595 + 8,194
D/(D+E) 0.00% 10.00% Second Iteration
D/E 0.00% 11.11%
$ Debt $0 $4,079 $4,079
EBITDA $3,268 $3,268 $3,268
Depreciation $1,517 $1,517 $1,517
EBIT $1,751 $1,751 $1,751
Interest Expense $0 $212 $224
Pre-tax Int. cov ∞ 8.26 7.80
Likely Rating AAA AA AA
Interest Rate 5.20% 5.50% 5.50%
The Ratings Table
If Interest Coverage Ratio is Estimated Bond Rating Default spread
> 8.50 AAA 0.20%
6.50 - 8.50 AA 0.50%
5.50 - 6.50 A+ 0.80%
4.25 - 5.50 A 1.00%
3.00 - 4.25 A– 1.25%
2.50 - 3.00 BBB 1.50%
2.00 - 2.50 BB 2.00%
1.75 - 2.00 B+ 2.50%
1.50 - 1.75 B 3.25%
1.25 - 1.50 B – 4.25%
0.80 - 1.25 CCC 5.00%
0.65 - 0.80 CC 6.00%
0.20 - 0.65 C 7.50%
< 0.20 D 10.00%
A Test: Can you do the 20% level?
D/(D+E) 0.00% 10.00% 20% Second Iteration
D/E 0.00% 11.11%
$ Debt $0 $4,079
EBITDA $3,268 $3,268 $3,268
Depreciation $1,517 $1,517 $1,517
EBIT $1,751 $1,751 $1,751
Interest Expense $0 $224
Pre-tax Int. cov ∞ 7.80
Likely Rating AAA AA
Interest Rate 5.20% 5.50%
Eff. Tax Rate 35.00% 35.00%
Bond Ratings, Cost of Debt and Debt Ratios
0% 105 20% 30% 40% 50% 60% 70% 80% 90%
EBITDA $ 3,268 $ 3,268 $ 3,268 $ 3,268 $ 3,268 $ 3,268 $ 3,268 $ 3,268 $ 3,268 $ 3,268 Depreciation $ 1,517 $ 1,517 $ 1,517 $ 1,517 $ 1,517 $ 1,517 $ 1,517 $ 1,517 $ 1,517 $ 1,517 EBIT $ 1,751 $ 1,751 $ 1,751 $ 1,751 $ 1,751 $ 1,751 $ 1,751 $ 1,751 $ 1,751 $ 1,751 Interest $ - $ 224 $ 510 $ 857 $ 1,632 $ 2,039 $ 2,692 $ 3,569 $ 4,079 $ 4,589
Pre-tax Int. cov ∞ 7.80 3.43 2.04 1.07 0.86 0.65 0.49 0.43 0.38
Likely Rating AAA AA A- BB CCC CCC CC C C C
Interest Rate 5.20% 5.50% 6.25% 7.00% 10.00% 10.00% 11.00% 12.50% 12.50% 12.50%
Eff. Tax Rate 35.00% 35.00% 35.00% 35.00% 35.00% 30.05% 22.76% 17.17% 15.02% 13.36%
Cost of Debt 3.38% 3.58% 4.06% 4.55% 6.50% 7.00% 8.50% 10.35% 10.62% 10.83%
Why does the tax rate change?
n You need taxable income for interest to provide a tax savings
40% 50%
EBIT $ 1,751 $ 1,751
Interest Expense $ 1,632 $ 2,039 Coverage ratio 1.07 0.86
Rating CCC CCC
Interest rate 10.00% 10.00%
Tax Rate 35.00% 30.05%
Cost of Debt 6.50% 7.00%
Maximum Tax Benefit = 35% of $1,751 = $613 million Tax Rate to use for cost of debt = 613/2039 = 30.05%
Boeing’s Cost of Capital Schedule
Debt Ratio Beta Cost of Equity Cost of Debt Cost of Capital
0% 0.87 9.79% 3.38% 9.79%
10% 0.93 10.14% 3.58% 9.48%
20% 1.01 10.57% 4.06% 9.27%
30% 1.11 11.13% 4.55% 9.16%
40% 1.25 11.87% 6.50% 9.72%
50% 1.48 13.15% 7.00% 10.07%
60% 1.88 15.35% 8.50% 11.24%
70% 2.56 19.06% 10.35% 12.97%
80% 3.83 26.09% 10.62% 13.72%
90% 7.67 47.18% 10.83% 14.47%
Boeing: Cost of Capital Chart
Costs of Equity, Debt and Capital: Boeing
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
40.00%
45.00%
50.00%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
Debt Ratio
8.00%
9.00%
10.00%
11.00%
12.00%
13.00%
14.00%
15.00%
Optimal Debt Ratio
The Home Depot: Cost of Capital Schedule
Debt Ratio Beta Cost of Equity Rating Interest rate Tax Rate Cost of Debt (After-tax) Cost of Capital
0% 0.84 9.64% AAA 5.20% 35.00% 3.38% 9.64%
10% 0.90 9.98% A 6.00% 35.00% 3.90% 9.37%
20% 0.98 10.40% BB 7.00% 35.00% 4.55% 9.23%
30% 1.08 10.93% CCC 10.00% 35.00% 6.50% 9.60%
40% 1.27 11.96% CC 11.00% 24.95% 8.26% 10.48%
50% 1.54 13.47% C 12.50% 17.56% 10.30% 11.89%
60% 1.92 15.58% C 12.50% 14.63% 10.67% 12.64%
70% 2.57 19.11% C 12.50% 12.54% 10.93% 13.39%
80% 3.85 26.17% C 12.50% 10.98% 11.13% 14.14%
90% 7.70 47.34% C 12.50% 9.76% 11.28% 14.89%
Effect of Moving to the Optimal on Firm Value
n Re-estimate firm value at each debt ratio, using the new cost of capital.
• For a stable growth firm, this would be
Firm Value = CF to Firm (1 + g) / (WACC -g)
• For a high growth firm, this would require that the cash flows during the high growth phase be estimated and discounted back.
n Estimate the annual savings in financing costs from the change in cost of capital and compute the present value of these savings in perpetuity.
n Annual Savings = (Cost of capitalbefore - Cost of capitalafter) Firm Value
• If you assume no growth in firm value, this would yield Annual Saving / Cost of capitalafter
• If you assume perpetual growth in savings, this would yield Annual Saving / (Cost of capital -g)
But what growth rate do we use? One solution
n The estimate of growth used in valuing a firm can clearly have significant implications for the final number.
n One way to bypass this estimation is to estimate the growth rate implied in today’s market value. For instance,
• Boeing’s current market value = 32,595 + 8,194 = $ 40,789 million
• Boeing’s free cash flow to the firm = $1,176 million
• Boeing’s current cost of capital = 9.17%
Assuming a perpetual growth model,
Firm Value = Cash flow to firm (1+g) / (Cost of capital - g) 40,789 = 1,176 (1+g)/(.0917-g)
Solving for g,
Implied growth rate = .0611 or 6.11%
Change in Firm Value for Boeing: Firm Valuation Approach
n Boeing’s free cash flow to the firm = $1,176 million
n Boeing’s implied growth rate = 6.11%
n New cost of capital = 9.16%
n Boeing’s new firm value = 1,176 *1.0611/(.0916-.0611)
= $ 40,990 million
n Boeing’s current firm value = $ 40,789 million
n Change in firm value = $ 40,990 - $40,789 = $201 million
Effect on Firm Value on Boeing: Annual Savings Approach
n Firm Value before the change = 32,595 + 8,194 = $ 40,789 million
WACCb = 9.17% Annual Cost = $62,068 *12.22%= $7,583 million WACCa = 9.16% Annual Cost = $62,068 *11.64% = $7,226 million
∆ WACC = 0.01% Change in Annual Cost = $ 6.14 million
n If there is no growth in the firm value, (Conservative Estimate)
• Increase in firm value = $ 6.14 / .0916 = $ 67 million
• Change in Stock Price = $ 67 /1010.7= $ 0.07 per share
n If there is growth (of 6.11%) in firm value over time,
• Increase in firm value = $ 6.14 /(.0916-.0611) = $ 206 million
• Change in Stock Price = $206/1010.7 = $ 0.20 per share
Effect on Firm Value of Moving to the Optimal:
The Home Depot
n Firm Value before the change = 85,668 + 4,081 = $ 89,749 million
WACCb = 9.51% Annual Cost = $89,749 *9.51%= $ 8,537 million WACCa = 9.23% Annual Cost = $89,749 *9.23% =$ 8,281 million
∆ WACC = 0.28% Change in Annual Cost = $ 256 million
n If there is growth (of 6%) in firm value over time,
• Increase in firm value = $ 256 (1.06) /(.0923-.06) = $ 8,406 million
• Change in Stock Price = $ 8,406/1478.63 = $ 5.69 per share
A Test: The Repurchase Price
n Let us suppose that the CFO of The Home Depot approached you
about buying back stock. He wants to know the maximum price that he should be willing to pay on the stock buyback. (The current price is $ 57.94) Assuming that firm value will grow by 6% a year, estimate the maximum price.
n What would happen to the stock price after the buyback if you were able to buy stock back at $ 57.94?
The Downside Risk
n Doing What-if analysis on Operating Income
• A. Standard Deviation Approach
– Standard Deviation In Past Operating Income
– Standard Deviation In Earnings (If Operating Income Is Unavailable) – Reduce Base Case By One Standard Deviation (Or More)
• B. Past Recession Approach
– Look At What Happened To Operating Income During The Last Recession.
(How Much Did It Drop In % Terms?)
– Reduce Current Operating Income By Same Magnitude n Constraint on Bond Ratings
Boeing’s Operating Income History
Year EBITDA % Change
1989 $ 1,217 19.54%
1990 $ 2,208 81.46%
1991 $ 2,785 26.15%
1992 $ 2,988 7.30%
1993 $ 2,722 -8.91%
1994 $ 2,302 -15.42%
1995 $ 1,998 -13.21%
1996 $ 3,750 87.69%
1997 $ 2,301 -38.64%
1998 $ 3,106 34.98%
Boeing: Operating Income and Optimal Capital Structure
% Drop in EBITDA EBITDA Optimal Debt Ratio
0% $ 3,268 30%
5% $ 3,105 20%
10% $ 2,941 20%
15% $ 2,778 10%
20% $ 2,614 0%
Constraints on Ratings
n Management often specifies a 'desired Rating' below which they do not want to fall.
n The rating constraint is driven by three factors
• it is one way of protecting against downside risk in operating income (so do not do both)
• a drop in ratings might affect operating income
• there is an ego factor associated with high ratings
n Caveat: Every Rating Constraint Has A Cost.
• Provide Management With A Clear Estimate Of How Much The Rating Constraint Costs By Calculating The Value Of The Firm Without The Rating Constraint And Comparing To The Value Of The Firm With The Rating Constraint.
Ratings Constraints for Boeing
n Assume that Boeing imposes a rating constraint of BBB or greater.
n The optimal debt ratio for Boeing is then 20% (see next page)
n The cost of imposing this rating constraint can then be calculated as follows:
Value at 30% Debt = $ 41,003 million - Value at 20% Debt = $ 39,416 million Cost of Rating Constraint = $ 1,587 million
What if you do not buy back stock..
n The optimal debt ratio is ultimately a function of the underlying riskiness of the business in which you operate and your tax rate
n Will the optimal be different if you took projects instead of buying back stock?
• NO. As long as the projects financed are in the same business mix that the company has always been in and your tax rate does not change
significantly.
• YES, if the projects are in entirely different types of businesses or if the tax rate is significantly different.
Analyzing Financial Service Firms
n The interest coverage ratios/ratings relationship is likely to be different for financial service firms.
n The definition of debt is messy for financial service firms. In general, using all debt for a financial service firm will lead to high debt ratios.
Use only interest-bearing long term debt in calculating debt ratios.
n The effect of ratings drops will be much more negative for financial service firms.
n There are likely to regulatory constraints on capital
